It
only took eleven years, but in 2011 global gold-mine production has
finally returned to pre-bull levels. In fact, with 2011’s volume
expected to come in at around 88m ounces, we’ll see a new
all-time production high. The latest
exploration-and-development cycle is finally starting to bear fruit!

This
fruit has been hard-earned though, as the miners have had to reverse
the course of a brutal
production
decline that bottomed out in 2008. Incredibly global gold
production had fallen nearly 13% in five years from 2003’s high, to
a level not seen since the mid-1990s. And needless to say that
painted quite an alarming fundamental picture considering demand was
on the rise.

Thankfully in the last three years the miners have diligently worked
to grow production, adding about 15m ounces per year to supply at
2011’s rate. And we’ve seen this production growth on a variety of
different fronts. The miners have brought back to life
past-producing mines that now have positive economics at the current
gold price, they’ve expanded existing mines to push through more
material, and they’ve built brand-new mines to tap the latest
generation of discoveries.

This
growth is the product of billions of dollars of capital investment,
along with a healthy dose of blood, sweat, and tears. Gold mining
is a tough business, especially in a world where gold is getting
harder and harder to find. And the miners in the trenches getting
their hands dirty to bring us the shiny-yellow metal we so crave
must be rewarded for their endeavors.

This
reward comes in two main forms, profits and stock appreciation. If
a miner can sell its gold for more than what it costs to produce it,
it should make a profit. And operating profitably obviously goes a
long way towards its stock price heading higher. As investors, both
profits and stock appreciation capture our attention. And with now
hundreds of gold-producer stocks to choose from, we have a myriad of
options.

One
way to break down these options, at a high level, is to figure out
where the miners fall in the global supply chain. By categorizing
the miners into like peer groups, investors have a mechanism for
identifying outperformers and underperformers, while also gauging
risk.

First and foremost are the majors, which naturally own the largest
piece of the production pie by far. And thankfully many of these
miners have NYSE listings, giving investors easy access to their
liquid stocks. As a group most of the world’s biggest and best
gold-mining stocks reside within the venerable NYSE Arca Gold BUGS
Index (HUI).

The
HUI is comprised of 16 stocks (most of which are dual-listed on the
Toronto Stock Exchange), including the world’s six largest gold
miners (Barrick Gold, Newmont Mining, AngloGold Ashanti, Gold
Fields, Goldcorp, and Kinross Gold). This index is rounded out by
several other top major and intermediate producers. And with
combined production of around 33m ounces, it is the bellwether
vehicle that investors look to for strategic movements in the
gold-stock sector.

But
though the HUI components combine to account for about 38% of gold’s
total mined supply, 50m+ ounces per year of production coming from
outside this camp naturally allows for many more investment
options. Interestingly though, most investors aren’t familiar with
where the rest of these ounces come from.

Even
though the US and Canada tend to be the hubs for natural-resources
stocks, particularly gold stocks, not all companies list on their
big-board exchanges. Companies like Newcrest Mining (world #7,
~2.5m ounces) and Polyus Gold (world #10, ~1.5m ounces) have their
respective primary listings in Australia and London for example. US
investors can buy these stocks via the Pink Sheets, but that realm
is only for experienced traders.

Another big chunk of this 50m+ ounces are from mining companies that
produce gold as a byproduct, with Freeport-McMoRan being the best
example. Even though FCX produces about 1.6m ounces of gold per
year (ranking it in the top 10), it is better known as the world’s
largest publicly-traded copper miner. FCX’s gold only accounts for
about a fifth of its total revenue. There are many other mining
companies like FCX that do produce gold, but as a subservient
mineral to say copper, zinc, or silver. These companies’ stocks are
not what investors should own if they are looking for gold
exposure.

Also
part of non-HUI gold production is the 11m or so ounces produced in
China, and the nearly 3m ounces produced in Uzbekistan. And
unfortunately most of these ounces are inaccessible to US
investors. As for China, while there are some exchange-listed
companies (Zijin Mining Group listed on the Hong Kong Stock Exchange
is the largest), the majority of its gold is produced by smaller
miners that are either government-owned, don’t have a stock listing,
or are illegal. And since most of the gold production in this
country is consumed domestically, there isn’t much motivation to
formalize China’s gold-mining industry.

In
Uzbekistan most of its gold comes from the massive Muruntau mine,
the largest open-pit primary gold mine in the world (~1.8m ounces).
Interestingly Newmont was in this country for a while, producing
gold from Muruntau’s tailings, but its assets were illegally
expropriated. Muruntau, another massive gold mine under
development, and the rest of the Uzbek gold mines are operated by
state-owned companies. And this precludes any type of foreign
investment.

Moving down the rungs are the world’s intermediate, or mid-tier,
gold miners. And thankfully investors have dozens of options with
their stocks. In the US and Canadian markets investors have access
to such companies as AuRico Gold (~470k ounces), Alacer Gold (~440k
ounces), and Osisko Mining (~640k ounces). And in the foreign
markets Petropavlovsk (~680k ounces) and St Barbara (~350k ounces)
are among the better known.

I
categorize this mid-tier group as those miners that produce between
200k and 800k ounces of gold per year. From a risk perspective
these mid-tiers are naturally going to be a bit more risky than the
majors. They usually don’t have the operational diversification and
financial strength of the majors. And because of their smaller
size, they tend to hold more downside risk when gold stocks fall out
of favor. But their smaller size does have its benefits. The
mid-tiers are always acquisition targets, and they can move to the
upside a lot faster when capital chases gold stocks.

Rounding out the mined supply of gold are those ounces attributable
to the juniors. Junior producers are gold companies that produce
less than 200k ounces per year. And it is in this realm where
investors will find the most abundant population of stocks. In my
recent survey of junior producers, I tallied nearly 100 that list in
the US and Canada alone. And it is these stocks that offer
investors the biggest risk/reward trade-off.

Even
though the output of any individual junior is miniscule in the grand
scheme of things, in aggregate this group is very important in the
global supply chain. In 2011 these miners produced a combined 5.5m+
ounces, which is very material. But even more important than this
volume is their role in the gold-mining ecosystem.

Provocatively most juniors either didn’t exist or weren’t producing
gold a decade ago when this bull was just getting started. Capital
from retail investors, their primary source of funding, was
essentially non-existent. Gold mining was not sexy, and there
wasn’t much money to be made with where gold’s price was at.

But
as gold gained popularity, and appreciated in price, the market for
these juniors quickly opened up. Investors craved the rapid gains
that could be won with these stocks, and the larger producers were
desperate to replace their reserves and bolster their portfolios
(most of which were quite neglected amidst gold’s secular bear).

The
entrepreneurial geologists that formed these juniors were among the
first to take the risk of exploring for gold in this new bull. They
risked their capital and their livelihoods scouring the world for
the next generation of gold deposits. And over the last decade
they’ve been invaluable contributors to the supply chain.

Juniors’ contributions have been both seen and unseen over the
course of this bull. Seen are the juniors operating their own mines
today. And unseen are those countless many that have been
acquired. It’s no secret that many of the new mines that the
mid-tiers and majors are bringing online were originally discovered
and/or developed by the juniors.

So
as investors, how are we to look at juniors? Most important is we
need to accept the juniors for what they are in the world of gold
stocks, risky. When you look at the profiles of these
companies, you’ll first notice that most operate only a single
mine. This obviously gives them a higher level of risk due to the
lack of diversification.

Junior producers also have financial risk, with their balance sheets
and cash flows nowhere near as strong as the mid-tiers and majors.
As for their balance sheets, the good news is most juniors don’t
have much debt since they raised most of their capital via equity
financings. But you’ll also find that most are cash-strapped, with
very little working capital. They are either recovering from the
big draws of a recent mine build, or are in the process of
aggressive exploration and/or development programs in their quests
to find/build their next gold mines.

Their balance sheets also tend to be weak due to a lack of
cash-building income. Even though these juniors are now generating
revenue, cash flow is not yet material enough to quickly build back
up the treasury. With average annual production of only 79k ounces,
the juniors aren’t exactly drowning in cash. Margins also tend not
to be as good in this realm, as juniors’ costs are on average higher
than those of their larger counterparts. As part of my research I
carefully examined cash operating costs. And as you see in the
chart below, this difference is quite substantial.

In
2011 the average cash operating costs for juniors was $723 per
ounce, compared to $574 per ounce for the larger miners that
comprise the HUI. On average it costs 26% more for the
juniors to produce their gold than the majors. This difference is
indeed considerable, and I’ve found there to be a number of reasons
for such a spread.

First and foremost it is imperative to understand that mining costs
in general, for all miners, have been sharply rising in recent
years. Amazingly back in 2006
average cash costs
for the world’s major gold miners was only $250. A double in only
five years seems excessive, but in reality things aren’t as
mismanaged as perceived. Some of this rise is naturally
attributable to rising materials, labor, and energy costs, but much
of it has to do with the quality of the ore sent through the mills.

With
the price of gold on the rise, miners have had the luxury of
intentionally “low-grading” existing operations (saving the
higher-grade material for lower gold prices). They’ve also been
building new mines on deposits that are either low-enough grade or
have complex-enough geology where the economics are only feasible at
higher prices, and juniors in particular fall into this camp.
Ultimately squeezing an ounce of gold out of the earth from
lower-quality/higher-complexity ore is going to be more costly.

Expanding on the ore-quality issue, junior producers often have a
tougher time planning and controlling their grades. Prior to
development many either don’t go through the effort (advanced
drilling and metallurgical testing) necessary to understand their
deposits, or don’t have the money to pay for feasibility studies
that would prove up their resources. When the
planning/engineering/design isn’t thorough, operations are likely to
struggle. And when the grade control isn’t optimized, costs are
going to be higher.

Overall juniors’ operational and financial risk definitely makes
their stocks more speculative than the larger gold stocks. But
don’t let their challenges dissuade you from dabbling in this
realm. The rewards for owning the right junior producers, at the
right time, can be legendary.

Remember that these juniors are producing gold in a gold bull. And
even if this gold is being produced at a higher average cost, there
is still plenty of margin to be had. Even at these higher
costs, 2011’s margins were some of the best ever seen. With 2011’s
average gold price of $1573, the majors and juniors scored
respective gross per-ounce cash margins of $999 and $850.
This is vastly better than 2006, where an average gold price of $604
yielded margins of only $350.

And
if the margin differential between the majors and juniors makes you
think twice about investing in these smaller producers, keep in mind
that it takes a lot more capital to push a high-market-cap
stock higher than it does a smaller-market-cap stock. When gold
stocks gain popularity, it doesn’t take much capital chasing the
juniors for their stocks to soar higher.

It
is also important to consider the attractiveness of juniors as
growth stories and acquisition targets. Quality juniors won’t
remain juniors for long. They’ll either grow organically or via
mergers and acquisitions, or they’ll be snatched up by the larger
mining companies. And the majors are now really starting to swing
around their capital considering gold stocks’ general
undervaluation
after being out of favor for so long.

Most
important for investors considering juniors is effective due
diligence. The cash-cost average in the chart above is just that,
an average. Several juniors are producing their gold at costs over
$1000, and several are producing at costs under $500. Some juniors
are losing money, are poorly managed, and have low-quality assets.
Meanwhile others are making money hand over fist, have top-shelf
management teams, and own spectacular portfolios of assets.

As a
product of our latest round of research focused on junior gold
producers, we distilled the universe down to our favorite dozen that
are profiled in our new
report. We believe these stocks to be the elite in their group,
well-run gold miners with exceptional assets. Included in this
group are juniors that have recently commissioned brand-new mines,
those that are working to develop a second or third mine, and
several that fall into this category only as a temporary layover on
their way to becoming mid-tier producers. And to demonstrate their
quality relative to their peers, their average 2011 cash costs were
only $493.

At
Zeal we do this research not only to educate ourselves on a given
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The
bottom line is when the dust settles on 2011, the gold market will
likely have seen all-time record supply from mine production. The
miners have finally taken heed to the call of this gold bull, and as
a result stock investors have seen their options greatly expand over
the years.

The
reliable major producers continue marching along, pumping out a
large chunk of the global supply. The mid-tier group remains
strong, its population flowing and ebbing as graduating juniors
replace those leaving due to M&A. But the most dynamic group of all
is the juniors. Juniors have been paramount to the growth of this
industry, and they continue to pioneer the exploration and
development of the next generation of gold mines. Fortunately for
investors junior-producer stocks are plentiful, and the quality ones
have the potential to deliver huge gains.